What comes to mind when you hear the words asset allocation? Equity, debt, cash, gold and real estate. Probably art and commodities, if you are so inclined.
But there is much more to it. The money that we have is limited. Our time on this planet is limited. Our energy is limited. And how we efficiently allocate accordingly matters a great deal.
Morningstar’s director of personal finance, Christine Benz, directs our attention to what she calls the “big-picture allocations”, that will ultimately define whether you find success in life, and not just the financial kind.
Saving Allocation
It's hard to argue that any other allocation is more important to the success or failure of a financial plan than how much of your paycheck you spend and how much you save for later.
So many investors who are scrupulous about various aspects of portfolio management -- asset allocation and expense ratios -- are loosey goosey when it comes to their savings rates. Most people undersave, unfortunately.
One possible explanation is that it can be devilishly hard to figure out how much you'll actually need, especially for the ultralong-term goal of retirement. There are so many variables: longevity, market returns and inflation.
But we must attempt to put a finer point on whether our savings rate is adequate. Seeking guidance from a holistic financial planner is the gold standard. A good planner can help you quantify your goals, taking into account anticipated lifestyle changes in retirement as well as external assets like pensions, and will practice tough love if you're not on track with your savings rate. DIYers, meanwhile, can avail themselves of a combination of tools and benchmarks.
If you are a late-career accumulators, focus on turbocharging your retirement savings.
Also Read: Save like a Pessimist, Invest like an Optimist
Spending Allocation
Whether you're thinking about it or not, you're also making important decisions within the spending slice of your household finances. How are you apportioning your money across short- versus long-term expenditures? Are you prioritizing spending on stuff or on experiences? Does that luxury vehicle bring as much joy as you would get from a more modest one, if the lesser ride afforded you the opportunity to take your family on several amazing trips as well?
These are really personal decisions. What works for one household won’t work for another. Maybe you really do need that expensive SUV or daily Starbucks coffee to feel OK. Just be mindful about the choices you're making, and if you can find spots to economize without hurting your quality of life too much.
Also Read: Why does money slip through my fingers?
Household Capital Allocation
You have a finite set of money to direct in a given month or year. How much of that amount should go to investing versus debt paydown? Many households wing it on this front, but they could actually put a little bit of math into the decision-making.
Debt paydown, after all, promises a guaranteed return that's equal to whatever interest rate you're paying. That makes it fairly easy to calculate the return on investment of money steered toward paying down loans. Without a crystal ball, determining a return on investment for investing is more difficult, though the historic returns for various asset classes are a good starting point when calculating your portfolio's expected return.
Armed with some numbers on the expected return on your debt paydown versus investing in the market, you can then make well-founded decisions about how to allocate your capital. High-interest revolving credit card debt? Easy -- pay it off, as it's impossible to out-earn that guaranteed rate with any type of investment. Look at the tax benefits on the loan too, in the case of education loan and home loan.
It's also worth noting that debt paydown doesn't provide liquidity, obviously, so if you are going to need the money any time soon, it's not an appropriate strategy.
Also Read: The psychology of debt repayment
Human-capital Allocation
Our human capital -- the earnings power of our skills, education and experience -- is the most valuable asset that most of us will have in our lifetimes. Are you using yours in a way that maximizes your returns over your lifetime?
Investing in human capital -- via additional education or training -- is close to a slam-dunk deployment of funds for early-career accumulators. If you can increase your earnings power with such an investment, you have a long time until retirement to benefit from it. The calculus isn't as simple as you get older; lifetime earnings may not offset the outlay of money and time for costly training later in life. Yet mid- and late-career accumulators should still make an ongoing investment in their own human capital -- taking advantage of continuing education programmes and conferences to enhance their skills, and networking. And no matter your life stage, staying current on the latest major technology developments and news, both on and off the job, is a crucial way to ensure that you stay relevant.
Also Read: 3 Investment Hacks for young people
Time-on-earth Allocation
Squishier, but even more important than all of the above: How are you allocating your precious time? Have you found the right balance of activities that make money, bring you joy and do some good in this world? Better yet, can you find an occupation that balances all three in a way that's agreeable to you?
This is the mother of all allocation decisions. It deserves frequent monitoring.
Also Read: Your money goals should match your life